When one company acquires another, the purchase price is allocated to all of the identifiable assets (tangible and intangible) and liabilities acquired, based on fair value. If the purchase price is greater than the fair value of the identifiable assets and liabilities acquired, the excess amount is recognised as an asset, goodwill.
- First, certain items not recognised in the acquiree’s financial statements (e.g., its reputation, established distribution system, trained employees) have value.
- Second, a target company’s expenditures in research and development may not have resulted in a separately identifiable asset that meets the criteria for recognition but nonetheless may have created some value.
- Third, part of the value of an acquisition may arise from improved strategic positioning versus a competitor or from perceived synergies such as operating cost saving opportunities after the acquisition.
The subject of recognising goodwill in financial statements has both proponents and opponents.
The proponents of goodwill recognition assert that goodwill is the present value of excess returns that a company is expected to earn. This group claims that determining the present value of these excess returns is analogous to determining the present value of future cash flows associated with other assets and projects.
Opponents of goodwill recognition claim that the prices paid for acquisitions often turn out to be based on unrealistic expectations, thereby leading to future write-offs of goodwill.
Analysts should distinguish between accounting goodwill and economic goodwill.
- Economic goodwill is based on the economic performance of the entity.
- Accounting goodwill is based on accounting standards and is reported only in the case of acquisitions.
Under both IFRS and US GAAP, accounting goodwill arising from acquisitions is capitalised.
Accounting standards’ requirements for recognising goodwill can be summarised by the following steps:
- Step 1: The total cost to purchase the target company (the acquiree) is determined.
- Step 2: The acquiree’s identifiable assets are measured at fair value. The acquiree’s liabilities and contingent liabilities are measured at fair value. The difference between the fair value of identifiable assets and the fair value of the liabilities and contingent liabilities equals the net identifiable assets acquired.
- Step 3: Goodwill arising from the purchase is the excess of (1) the cost to purchase the target company over (2) the net identifiable assets acquired. Occasionally, a transaction will involve the purchase of net identifiable assets with a value greater than the cost to purchase. Such a transaction is called a “bargain purchase.” Any gain from a bargain purchase is recognised in profit and loss in the period in which it arises.
The recognition and impairment of goodwill can significantly affect the comparability of financial statements between companies. Therefore, analysts often adjust the companies’ financial statements by removing the impact of goodwill. Such adjustments include the following:
- excluding goodwill from balance sheet data used to compute financial ratios, and
- excluding goodwill impairment losses from income data used to examine operating trends.
